Inflation Targeting

What Is Inflation Targeting?

Inflation targeting is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation. The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation.

Understanding Inflation Targeting

As a strategy, inflation targeting views the primary goal of the central bank as maintaining price stability. All of the tools of monetary policy that a central bank has, including open market operations and discount lending, can be employed in a general strategy of inflation targeting. Inflation targeting can be contrasted to strategies of central banks aimed at other measures of economic performance as their primary goals, such as targeting currency exchange rates, the unemployment rate, or the rate of nominal gross domestic product (GDP) growth.

Interest rates can be an intermediate target that central banks use in inflation targeting. The central bank will lower or raise interest rates based on whether it thinks inflation is below or above a target threshold. Raising interest rates is said to slow inflation and therefore slow economic growth. Lowering interest rates is believed to boost inflation and speed up economic growth. 

The benchmark used for inflation targeting is typically a price index of a basket of consumer goods, such as the Personal Consumption Expenditures Price Index that is used by the U.S. Federal Reserve.

Along with taking inflation target rates and calendar dates as performance measures, inflation targeting policy may also have established steps that are to be taken depending on how much the actual inflation rate varies from the targeted level, such as cutting lending rates or adding liquidity to the economy.

On August 27, 2020 the Federal Reserve announced that it will no longer raise interest rates due to unemployment falling below a certain level if inflation remains low. It also changed its inflation target to an average, meaning that it will allow inflation to rise somewhat above its 2% target to make up for periods when it was below 2%.

Pros and Cons of Inflation Targeting

Inflation targeting allows central banks to respond to shocks to the domestic economy and focus on domestic considerations. Stable inflation reduces investor uncertainty, allows investors to predict changes in interest rates, and anchors inflation expectations. If the target is published, inflation targeting also allows for greater transparency in monetary policy.

However, some analysts believe that a focus on inflation targeting for price stability creates an atmosphere in which unsustainable speculative bubbles and other distortions in the economy, such as that which produced the 2008 financial crisis, can thrive unchecked (at least until the inflation trickles down from asset prices into retail consumer prices).

Other critics of inflation targeting believe that it encourages inadequate responses to terms-of-trade shocks or supply shocks. Critics argue that exchange rate targeting or nominal GDP targeting would create more economic stability.

Since 2012, the U.S. Federal Reserve has targeted inflation at 2% as measured by PCE inflation. Keeping inflation low is one of the Federal Reserve's dual mandate objectives, along with stable, low unemployment levels. Inflation levels of 1% to 2% per year are generally considered acceptable, while inflation rates greater than 3% represents a dangerous zone that could cause the currency to become devalued. The Taylor Rule is an econometric model that says the Federal Reserve should raise interest rates when inflation or GDP growth rates are higher than desired.

Inflation targeting became a central goal of the Federal Reserve in January 2012 after the fallout of the 2008-2009 financial crisis. By signaling inflation rates as an explicit goal, the Federal Reserve hoped it would help promote their dual mandate: low unemployment supporting stable prices. Despite the Federal Reserve's best efforts, inflation still fluctuates around the 2% target for most years.